A Counterparty Risk Study of UK Banking Systems

Abstract

We study the effect of counterparty risk on the stability of a banking system using stylized banking cascade models calibrated with UK exposure and balance sheet data from regulatory reports. We observe the development of a fragile phase, at which small perturbations to banks' capital reserves can trigger a sudden system failure. We compute the critical balance sheet values for a stylized homogeneous system and show that a more realistic heterogeneous system, with different bank types and complex interbank network calibrated on UK data, also has systemic failures around similar sized shocks to banks' capital as the stylized homogeneous system. By aggregating the fraction of surviving banks to specific bank types, we show that balance sheet size and banks' position in the interbank network are not the decisive components when considering system failure due to counterparty insolvency. This implies that interbank network structure and heterogeneity do not play a critical role in the onset of the fragile phase. Instead, the onset of the system failure depends on the ratios of interbank assets to total assets and loss absorbing capital to total assets. Finally, we discuss the effects of increased exposure of specific banks and we compute minimum capital requirements to ensure a stable banking system.